Categories/Tabs

Friday, 15 November 2013

To What Extent Does a Rational Economic Man Exist?

By Timur Almazov

Economic theories are meant to represent patterns of the real market, but since we live in a complicated world, economists have to simplify the reality to fit economic models. They have included assumptions into their theories and the idea of rational economic man was one of the most popular ones. Its purpose was to describe the preferences and actions of humans, but to cut long story short, it didn’t do a good job.

The definition of an economic man is: a rational and selfish agent, whose preferences do not change. In this essay and in the longer version I have looked at the assumptions of economic rationality and how close it is in describing us as “rational”. Most economists agree that rational agents are those who have the same constant preferences (usually to make a profit) and make “internally consistent” decisions. This means that rational people follow logical coherence, which does not necessarily have to be reasonable. A rational person can believe in magic as long as all of his or hers other beliefs are consistent with the existence of magic.

In reality, however, people make economically irrational decisions, mainly due to emotions. Emotions, such as fairness, confidence and greed can affect one’s decision-making skills and lead to irrational outcomes. In some cases, they can even cause asset bubbles. For example, the Dotcom crash of 2000 was a result of investors’ trust in what they perceived was a “new economy”. There was an enormous flow of investments into Silicon Valley companies most of which ended up either bankrupt or not profitable enough. The investors got carried away with great ideas of the Internet – a new paradigm, and dismissed the actual business plans of the firms they were investing in. The confidence in the “new market” was so high that some of the Internet and technology companies’ IPOs (first sale of private stock to the public) doubled in price on the first day. The investors were willing to give millions of dollars to the firms and expected them to become the next Microsoft. In reality most of the firms had poor business plans and were expecting small or even zero profits. As the time went by, the confidence started to fade with more and more information pointing out that most of the dotcom firms are not going to be profitable. Eventually after companies burned up through their venture capital, they ceased trading and caused a panic among their investors. By 2001 the bubble was quickly deflating and the NASDAQ stock market, which largely consisted of IT companies, lost 78% of its value from March 2000 to September 2002. If, on the other hand, people acted rationally and examined the future profit expectations of the dotcom firms, then the market crash would have been avoided.

The truth is, we are far from being economically rational and trying to deny this does not help us. We have avoided discussing the problems that can arise from irrationality and this led to some… unexpected incidents. If we want to build a better market and a stronger economy, avoid risk of overpriced assets and improve the efficiency of investments, then we have to look carefully at ourselves, examine ourselves and create the models that fit us. The assumption of rational economic man has long been outdated and it is time for us to create a much clearer description of human agents in the economy. The way to do that is to look into psychology, but that is a topic for a whole new essay.

This was a summary of a longer essay written by Timur. Click here to read the full essay.